MANILA, March 12 (Reuters) - Philippine President Gloria Macapagal Arroyo ordered the army on Monday to be restrained in dealing with the largest Islamic rebel group in the country and prevent clashes which could torpedo a peace process.

Arroyo, worried over the intermittent fighting between troops and the Moro Islamic Liberation Front (MILF) in farming villages in the south since late January, met the cabinet and senior security officials to discuss ways to prevent further violence.

"I have also ordered restraint in the use of artillery and aerial bombing in the conduct of military operations," Arroyo said in a statement.

She ordered the military to increase vigilance against those intent on breaking the peace and agitating the people and pitting the government against the MILF. "The best course of action to ensure that the hostilities do not escalate and are exploited by lawless elements is for the armed forces to work closely with established mechanisms of the peace process."

Last week, soldiers and Muslim rebels exchanged artillery and mortar fire in the village of Midsayap that left 20 people dead, including a soldier.

A member of an international peace monitoring team in the area said the MILF lost nine fighters but another 10 armed civilians, most of them in their teens, were among those killed.

The fighting came four days after Japan's development agency unveiled $3 million worth of community projects in conflict areas in the south, part of Tokyo's contribution to push the two sides to sign a peace deal ending nearly 40 years of fighting.

Talks, brokered by Malaysia since 2001, had been stalled last year over the size and wealth of a proposed ancestral homeland for 3 million Muslims in the south of the mainly Roman Catholic country in Southeast Asia.

Al Haj Murad, MILF leader since 2003, has said there has been a breakthrough during an informal meeting last December when Manila had offered to recognise the rights of Muslims to self-determination.

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